The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Wednesday, June 27, 2012

Like US and Irish financial regulators, Spain's missed or downplayed problems in banking sector

The NY Times carried a terrific article exploring yet another example of financial regulators publicly downplaying the risks in their banking systems.

This article confirmed a principal finding of the Nyberg report on the Irish financial crisis that the current structure of bank supervision causes financial instability because it suppresses expressing dissenting opinions on the riskiness of the financial system to the public.

While your humble blogger appreciates that regulators don't want to say anything that would cause market participants to question the safety and soundness of the banks or potentially trigger a bank run, this lack of criticism creates several problems.

First, it contributes to market participants mis-pricing the risk of the banks. Since the regulators have an informational monopoly on the data needed to fully assess the risk of the banks, the regulators statements influence the perception of risk at the banks.

Second, it undermines the credibility of the government when it comes to dealing with a financial crisis. Has anyone else noticed a cycle under which policymakers and financial regulators roll out a solution, sound the all clear and then repeat the exercise when the solution is shown as inadequate?

Regular readers know that your humble blogger proposed a new model for bank supervision that ends these problems. The model is based on the idea of ending the financial regulators' information monopoly.

Specifically, it requires the banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details. With this information, market participants can assess the risk of each bank for themselves.

As a result, regulators do not have to offer up an opinion on the banks. In fact, the regulators can easily piggyback off of the markets' analytical capability in their internal assessment of the banks.

It ends the cycle of inadequate solutions. In particular, it ends the perception that governments and banks are hiding something.

As Spain edged closer to a real estate and banking crisis that led to its recent bank bailout, Spanish financial leaders in influential positions mostly played down concerns that something might go terribly wrong.

The optimism of Spanish central bankers who went on to top jobs at the International Monetary Fund echoes the attitudes of officials in the United States who misjudged the force of a housing collapse several years ago that crippled banks and the economy. And it underscores the complications that can arise when government officials take watchdog roles at international agencies that pass judgment on the policies they once directed....

From their lofty perches, first at Spain’s central bank and then as the I.M.F.’s top executives assessing global banking risk, José Viñals and Jaime Caruana were well positioned to sound alarms about the looming bank debacle.

But at a news conference in Washington in April 2010, when analysts were raising red flags about failing Spanish real estate loans, Mr. Viñals — who a year earlier had succeeded Mr. Caruana — offered assurances. The Spanish system was “fundamentally sound,” he said, and its needs for cash “very small.”

A year later, as the banking crisis showed little sign of improving, Mr. Viñals again called for calm, saying the market panic that had led to bailouts in Ireland and Portugal would not infect Spain.

Now that the recent failure of Bankia, the big mortgage lender, has prompted a 100 billion euro (about $125 billion) European rescue, it is clear that Mr. Viñals’s forecasts were too sanguine.

Mr. Caruana was no more prescient. Pressed at an I.M.F. news conference in July 2008 about falling house prices in Spain, he acknowledged there might be loan losses. But he said, “The financial system in Spain is able to cope with that and is properly capitalized.”...

The names have changed, but the same story could be told of senior bank regulators in Ireland and the US.

Certainly, Spanish officials were slow to acknowledge the depths of the problem.

In early May, Rodrigo Rato, then the executive chairman of Bankia, told journalists that the bank was in a situation of “great robustness, both in terms of solvency and liquidity.”

Even after the bank’s bailout a few days later, Spain’s economy minister predicted that no more than 15 billion euros of public funds would be required to clean up the banks....

Officials everywhere have been slow to acknowledge the depths of the problem.

Most prominent by far was Mr. Rato, now better known for his disastrous two-year run at the helm of Bankia. In 2004, he was picked to lead the I.M.F. after winning global recognition during an eight-year run supervising Spain’s growth burst as the country’s economy minister.

Until he left the fund three years later, Mr. Rato was better known for praising Spain’s economic miracle — one that relied largely on revenue driven by real estate to drive growth and balance budgets — than questioning its sustainability.

He considered himself the intellectual father of that miracle, as he made clear in a 2004 speech, citing his reforms as marking “a new era in economic policy” for Spain. Mr. Rato, too, declined to be interviewed for this article.

There were many others, of course, who did not foresee the Spanish banking blowup.

Topping the list is Europe’s main bank overseer, the European Banking Authority.

In December 2011, the authority concluded that Spain’s two strongest institutions — Santander and BBVA — would need to raise more money than the 1.3 billion euros that was required of Bankia, which would need to be rescued just six months later....

In Spain, the increase in house prices between 2000 and 2007 was particularly extreme — so much so that as early as 2006, a team of inspectors within the Bank of Spain sent a cautionary report to the government.

The study criticized the “passive attitude” of Mr. Caruana, who led the central bank from 2000 to 2006, and the extraordinary acceleration of loans to homebuyers and real estate developers.

The inspectors also warned of Spanish banks engaging in unusually heavy short-term borrowing at levels far beyond their deposits.

The 2006 report painted a much darker picture than Mr. Rato and the I.M.F. saw a short time later when the fund made its own assessment in 2007 of Spain’s economic and financial health — and the Bank of Spain’s ability to rein in excesses.

The analysis praised the “dynamism of Spain’s financial system,” and said that “its strong, prudential supervision and regulation remain a forte of the economy.”...

In fact, up through the 2008 global financial crisis, Bank of Spain officials had become the toast of the international regulatory circuit for their innovations. Most notable of those was a so-called dynamic provisioning policy, a set of rules that forces banks to set aside extra cash during good economic times to protect against the inevitable rainy days.

For a time, Spanish financial institutions were hailed as paragons of responsible banking — having set aside over 110 billion euros in reserves.

But José Garcia Montalvo, a real estate specialist based in Barcelona, says that this figure could have been higher — and the banks better prepared for the housing collapse when it came.

The reserves proved insufficient, he said, because the Spanish central bank in 2004, led then by Mr. Caruana, succumbed to bank lobbying and pressure from Europe by halving the amount that banks had to set aside to 15 percent of overall loans, from 30 percent.

From that point, Spanish bank lending, already growing at 14 percent annually, went into overdrive — up 27 percent in 2005 and an additional 25 percent in 2006.

Yet another replay of the Irish experience.

Mr. Caruana’s career has since thrived. After just three years at the I.M.F., he left in 2009 for one of the plum global finance jobs: chief executive of the Bank for International Settlements, the Basel-based regulatory body that serves as a forum for the world’s central banks.

Last weekend, in a speech that explored the roots of the financial crisis, Mr. Caruana highlighted the economic distortions caused by frantic real estate lending, and he called for banks to be quicker to recognize losses and raise capital — although he did not mention Spain by name

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.